Islamic vs. conventional banking: business model, efficiency and stability

Abstract

This is the accepted version of the paper.This version of the publication may differ from the final published version. Islamic banks, controlling for time-variant country-fixed effects, we find few significant differences in business orientation. There is evidence however, that Islamic banks are less cost-effective, but have a higher intermediation ratio, higher asset quality and are better capitalized. We also find large crosscountry variation in the differences between conventional and Islamic banks as well as across Islamic banks of different sizes. Furthermore, we find that Islamic banks are better capitalized, have higher asset quality and are less likely to disintermediate during crises. The better stock performance of listed Islamic banks during the recent crisis is also due to their higher capitalization and better asset quality. Permanent repository link Cover Letter *Detailed Response to ReviewersWe compare conventional and Islamic banks across 22 countries with both bank types. Abstract: How different are Islamic banks from conventional banks? Does the recent crisis justify a closer look at the Sharia-compliant business model for banking? When comparing conventional and Islamic banks, controlling for time-variant country-fixed effects, we find few significant differences in business orientation. There is evidence however, that Islamic banks are less cost-effective, but have a higher intermediation ratio, higher asset quality and are better capitalized. We also find large cross-country variation in the differences between conventional and Islamic banks as well as across Islamic banks of different sizes. Furthermore, we find that Islamic banks are better capitalized, have higher asset quality and are less likely to disintermediate during crises. The better stock performance of listed Islamic banks during the recent crisis is also due to their higher capitalization and better asset quality.JEL classification: G21; G01; Z12

The governance, risk-taking, and performance of Islamic banks

“…The interest-free financial system has attracted considerable attention from corporations, policy makers, and other stakeholders. Beck et al (2013) find few significant differences between the business models of Islamic banks. They find evidence that Islamic banks are less cost effective but have a higher intermediation ratio, higher asset quality, and better capitalization.…”

“…The literature often separates the examination of issues pertaining to Islamic and conventional banks into the differences between their respective business models (Beck et al 2013). Islamic banks differ from conventional banks through the imposition of certain religious principles on the products offered, which are free from the establishment of interest (riba) (see, e.g., Obaidullah 2005) and excessive uncertainty (gharar) (Abedifar et al 2013).…”

“…Additionally, profit-loss sharing mechanisms use equity financing and risk sharing, as compared to conventional banks that use debt financing (Beck et al 2013) and risk transference (Hasan and Dridi 2010). Relationship banking in Islamic banks can also act to reduce adverse selection and moral hazard problems through monitoring by depositors.…”

“…In conventional banks, relationship banking is confined to private banking services for prime clients, but in Islamic banking a close relationship between the bank and the client comes from shared values, trust, and mutual respect. Thus, some of the risks of Islamic banks can be mitigated by reducing transaction costs and mitigating agency conflicts through monitoring by depositors rather than government intervention, such as deposit insurance (Beck et al 2013). Alman (2012) elaborates that Shari'ah supervision mitigates risk taking.…”

“…First, this is the first cross-country study that examines the influence of the governance structure on the risk taking and financial performance of Islamic banks. By simultaneously analyzing both Islamic banks and conventional banks, we complement the works of Cihak and Hesse (2010), Hasan and Dridi (2010), Abedifar et al (2013), Beck et al (2013), andMollah andZaman (2015).…”